ESG in infrastructure: Laying the groundwork

Chang Sun, who stepped down as Asia-Pacific chairman at Warburg Pincus to found agriculture-focused investment and operating company Black Soil, sees an ecological disaster unfolding in China, largely unnoticed.

Groundwater levels in some communities are dropping by as much as 1-2 meters per year due to unrestrained well drilling. With the chronic lack of rainfall, this means the water available for irrigation is shrinking while demand for food is rapidly growing. Sun believes that these problems could be addressed by government intervention, but finds the combination of indifferent stewardship by landowners and misplaced government priorities dispiriting.

"The government is paying a lot of attention to the issue, they just don't take action," Sun told the AVCJ ESG Forum. "They give trillions of renminbi per year in direct subsidies. But due to the fear of corruption, they pay directly to the bank accounts of the farmers, who have already moved to the cities. So they're pocketing the money, and not really paying attention to the land that they're supposed to farm."

When we talk about Asia, it's not just one Asia. It's all different. And some of the sustainability issues are very local, like water. So if you don't go there, you just don't know - Y.K. Park

While governments in Asia are making progress on environmental issues, bureaucratic inertia and inadequate education mean that important steps still have not been taken. In this climate, investors believe there is an opportunity for private equity to play a leadership role by enforcing environmental, social and governance (ESG) standards at the investment level, independent of government.

By setting standards and holding investees to them, GPs can do for local infrastructure what central planners apparently cannot.

Local complexities

Addressing emerging environmental dangers is complicated by the fact that regulations are very much a patchwork quilt. Ecological risks differ between and even within countries; for example, water shortages in northern China are not as severe in other parts of the country. This means that those most affected by a problem may not be able to make the case for preventive infrastructure investments to those in power.

This is not to say there has been no movement on environmental issues recently. Christophe Bongars, founder and CEO of Asia Pacific greentech investment advisory SustainAsia, remarks that just 10 years ago, the Chinese government paid little attention to climate change. Now officials have come to see environmental topics as opportunities.

"Not only are they addressing the energy security aspects, but also they've understood that there is a growing market for so-called clean technology," Bongars says. "In the solar industry, China is number one in the world. In wind energy, by the number of wind farms it's the fastest growing market in the world."

Despite these developments, regulatory evolution is uneven, which means the risk-return dynamic can vary hugely by market. Progressive measures introduced in one country will have no effect in another if the government does not consider the issue to be a priority. Also complicating matters is the fact that high-level officials who understand environmental problems on a broad level may not grasp their importance to the local population.

"When we talk about Asia, it's not just one Asia. It's all different," says Y.K. Park, director of sustainability and governance at Dutch pension fund asset manager APG. "And some of the sustainability issues are very local, like water. So if you don't go there, you just don't know."

Taking action

With government action lagging behind needs, industry players see a chance for private equity to step in and play a leadership role in helping local communities put needed infrastructure in place.

An effective way to do this is to invest in local infrastructure projects. SustainAsia recently helped German waste management company Alba tender for a project to build and operate an electronic waste recycling facility in Hong Kong. Bongars says this shows the necessity of taking a broad regional view for available projects, but also of understanding local needs.

"When you go into this type of infrastructure business, you need to look at it from the top down, and very high level macro," says Bongars. "And very quickly you need to narrow down to that particular situation. It can be very localized, and very strongly affected by local regulations."

There are risks to this approach, however. Circumstances might change after investors have committed capital. APG's Park remembers one case, in which the firm invested in a chemical plant in China. When the deal closed, the nearby town was still small and the reservoir was mostly unused. The investment team assumed the plant would have access to most of the water.

"It wasn't the case, because that little town became a mid-sized town, and then other industries came in," says Park. "We couldn't actually use the whole water, so we had to give up about 60%." With such a small amount of water, the plant could not operate efficiently.

If a GP decides to pursue this approach, it must be prepared to adapt the PE model to the needs of the sector. It can mean working against conventional wisdom - for instance, that infrastructure investments only pay off over a long term. While operating contracts can run several decades, there are ways to mitigate this. Exiting to a local partner is a popular option.

Park points out that LPs must also be willing to strictly enforce ESG standards on their GPs, even to the point of backing out of investments.

"Putting money in so that all the ESG things will be okay is not enough," she says. "You need to put terms in the legal document, and then the next thing is monitoring. I monitor the progress made by the managers. Over time if progress is not delivered, then there is not going to be any follow-on investment."

Investing with an eye toward sustainability may not offer lucrative rewards right away. However, GPs that show a leadership role early on will have laid the groundwork for long-term participation in a more sustainable future.

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• Topics
• Infrastructure
• Greater China
• South Asia
• Regulation
• regulation
• Infrastructure
• ESG
• Agriculture
• Asia
• China
• India
• APG